Credit-Default Swaps

（Prof. Hong Yan talked in an article on the Wall Street Journal. He
pointed out that it could be potentially dangerous that CDS spreads are often
quoted as readily as the DJ industrial average nowadays. ）

Wall
Street is glued to a gauge of trading fear that has surprisingly few trades behind
it.

In recent years, credit-default swaps --
contracts that give the buyer the right to collect a payment from the seller if
a borrower defaults on its obligations -- have risen from obscurity to an
avidly tracked barometer of the financial health of everything from Bank of
America Corp. to Greece.

In some
cases they have even come to serve as a stand-in for stock quotes when U.S.
exchanges are closed.

Before
stock markets opened in New York on Aug. 23, for example, the price quoted for
the cost of insuring against a default on Bank of America rose sharply, hitting
a record high. A Nomura Securities trader sent out an email alert citing the
derivatives price: "Ugly out there this morning."

Yet a
Wall Street Journal analysis shows that actual trades in these widely cited
derivatives are few and far between -- and the quotes that market observers
bandy about often aren't based on actual trades at all.

While the
swaps can help investors’ hedge risks and bet on market trends, the thin
trading underlines a key shortcoming of an instrument that has a huge influence
on risk perceptions. During periods of stress, the actions of a few traders can
have an outsize impact on delicate market psychology.

"The
market does not fully understand the limitations in trading, or the lack of
liquidity, as CDS spreads are often quoted as readily as the DJ industrial
average nowadays," said Hong Yan, a professor of finance at Shanghai
Advanced Institute of Finance who is on leave from the University of South
Carolina. "This could be potentially dangerous in a very volatile and
uncertain market since CDS spreads are used much more frequently and
prevalently."

The
Journal analyzed data compiled by Depository Trust & Clearing Corp., a
central warehouse that collects swaps trading information from investment
banks. That analysis shows that even for the most popular credit-default swaps,
such as those for Bank of America debt, daily trading is dwarfed by that in the
stock market and often, too, in bonds.

For the
week ending Sept. 16, the most recent data available, the gross notional value
of swaps referencing Bank of America -- that is, the value of the contracts
outstanding -- rose from the prior week by $700 million, according to
Depository Trust.

By
comparison, some $8.5 billion of the Charlotte, N.C., company's stock traded
during the same week.

Despite
the thin trading, investment banks and media outlets frequently point to swaps
pricing as an indicator of the health of the global financial system's
constituent parts.

On
Tuesday, the limited trading was further highlighted in a Federal Reserve Bank
of New York paper that analyzed three months of swaps data for both single-name
corporate bonds and baskets of swaps. New York Fed officials sought to better
understand how frequently the derivatives trade amid regulatory efforts to
require investment banks to report real-time transaction data.

The study
found little actual trading.

"A
majority of the single-name reference entities traded less than once a day,
whereas the most active traded over 20 times per day," the New York Fed
paper said.

"The
CDS market, in general, is not like the fast-trading stock market," said
Darrell Duffie, a derivatives expert and finance professor at Stanford
University.

That
isn't to say there is no money at stake in the credit-default swap market. The
net notional value of swaps outstanding on Bank of America, for instance, was
$5.8 billion at Sept. 23, a similar level from the start of the year, according
to Depository Trust. That is the maximum amount of money that would be
exchanged in the event of a default.

The
contracts have been used for years by banks to unload risks they don't want and
by hedge funds and other investors to bet on changing market trends. But since
the financial crisis of 2008, they have been best known as a measure of market
stress.

In the
case of credit-default swaps for corporate bonds, a buyer pays a sum quarterly
for the derivative. If a bond defaults, the losses are covered by the seller of
the contract.

Costs of
the protection can rise if investors believe the underlying debt is getting
riskier. Those trading the swaps often are big banks or, to a lesser degree,
hedge funds.

Data
vendors such as Markit Group Ltd. and CMA, a unit of CMA Group, use computer
systems to extract swaps prices -- including quotes -- from electronic messages
between investment banks and investors.

The
companies aggregate that pricing data, which makes its way to a wider audience
seeking a gauge of default risk -- an audience that may not recognize the limitations
of the data they are looking at and the nature of how the derivatives trade.